Information Economics and Policy 4 (1989190) 281-290. North-Holland

INCENTIVE MECHANISMS FOR COST REVELATION WITH INTERMODAL COMPETITION

Michael A. EINHORN* Department of Economics, Rutgers University, Newark, NJ 07102, USA

To set regulated utility prices that are sustainable against uneconomic bypass alternatives, regulators must estimate the costs of the alternative bypass technologies; this entails a series of theoretical and institutional problems that regulators cannot practically resolve. This paper now develops a simple incentive mechanism that effectively solves those problems associated with producing an optimal amount of bypass. In the suggested procedure, regulators use readily available accounting data to specify one two-part tariff that covers the utility’s revenue requirements and is deemed fair by regulators and consumers; as long as it offers this fair tariff, the company may subsequently offer as many alternative tariffs as it sees fit, including some particularly aimed to deter bypass. This procedure gives a utility the correct incentive to determine its own and its rivals’ cost structures; with accurate cost information, the utility will design a menu of tariffs that would eliminate uneconomic bypass and would be responsive to changing cost conditions in the emerging bypass markets.

Keywords: Asymmetric information, bypass, incentive mechanisms, intermodal com-

petition, nonuniform pricing, regulation, tariff menu, two-part tariff.

1. Introduction

In the past ten years, much economic research has focused on regulation under imperfect information and moral hazard. Vogelsang and Finsinger (1979), Baron and Myerson (1982), Laffont and Tirole (1986), and Sappington and Sibley (1988) have designed efficiency-improving mechanisms for regulated utilities with private information regarding marginal production costs. Riordan (1984) offers strategies when regulated monopolies have private information about consumer demand; Lewis and Sappington (1988) consider simultaneous information asymmetries in both monopoly cost and customer demand.

Any regulatory strategy designed to streamline regulator workload or accom- modate problems involving information asymmetries must acknowledge another timely issue-the increasing freedom now granted to customers of regulated utilities to forego company service in favor of an unregulated intermodal competitor (Braeutigam, 1978). The most famous contemporary issue has been telephone bypass, which entails the exodus of large utility customers to alternative suppliers who may offer service at lower usage prices; the bypass issue also affects present-day regulatory markets in electricity and

* Helpful comments were made by Lorenzo Brown, Roger Nell, David Sibley, Ingo Vogel- sang, and two anonymous refs; I thank each. The Research Council of Rutgers provided partial funding.

0167-6245/91/$03.50 @ 1991-Elsevier Science Publishers B.V. All rights reserved

282 M. A. Einhorn I Incentive mechanisms for cost revelation with intermodal competition

natural gas distribution. If utility prices are set above marginal cost, producing customer bypass could be economically inefficient, resulting in needless over- expansion of bypass facilities at substantial social cost.

In order to set utility prices that are sustainable against uneconomic bypass alternatives, regulators must estimate the costs of the alternative technologies that are now emerging. This presents several problems. First, the alternative suppliers are not legally required to report their costs to any regulatory commission. Second, any cost estimation that does occur presents substantial room for strategic misrepresentation by the affected parties. Third, bypass technologies and costs can continually change and unanticipated low-cost entrants can always emerge; accurately forecasting the future costs of emerging bypass technologies would seem next to impossible.

In an earlier article (Einhorn, 1987), I derived a nonuniform price schedule for a profit-constrained, welfare-maximizing utility faced with bypass competi- tion for large customers. The paper demonstrated that regulators who are aware of the marginal costs of both the utility and the bypass alternatives could design a nonuniform price schedule that permits bypass if and only if it is economically efficient. However, the paper was cast in the assumptions of traditional cost-based regulation and displayed several practical drawbacks that would seriously limit its applicability. In particular, regulators needed to determine the marginal costs of both the regulated utility and the bypass service as well as a Bayesian distribution of customer demand intensities. As noted above, such requirements abound with information-related difficulties. In addition, traditional cost-based ratemaking may reduce the utility’s incentive to minimize its own costs.

In this paper, I examine whether a simple price-cap incentive mechanism can also solve the information and institutional problems that are associated with securing an optimal amount of bypass. In the procedure examined here, regulators use readily available accounting costs to specify the terms of one two-part tariff (A,, P,) that covers the utility’s revenue requirements and is deemed fair by regulators and consumers. After regulators set (A,, P,), the company may offer as many tariffs as it sees fit, including some particularly aimed to deter bypass; however, regulators require that no utility customer can be made worse off than under the designated fair tariff (A,, Pf). As a practical matter, a profit-maximizing utility could simply be required to include (A,, P,) in a menu of alternative two-part tariffs.

As will be shown, this procedure gives a utility the correct incentives to determine its own and, as best it can, its rivals’ marginal cost structures. Though measurement accuracy is not guaranteed, honest effort is. With accurate cost information, the utility’s tariff menu would eliminate uneconomic bypass and would be responsive to changing cost conditions in the emerging bypass markets. Finally, if the fair tariff (A,, Pf) were adjusted appropriately, the utility has a greater incentive to reduce costs, particularly in the face of bypass competition. Given the difficulty that regulators face in measuring producer costs and in gauging management efficiency, this approach may be the only practical means of ensuring that consumers make efficient bypass deci- sions.

M.A. Einhorn I Incentive mechanisms for cost revelation with intermodal competition 283

2. The fairness constraint

The regulator’s aim is to determine a price schedule that covers the revenue requirements of the regulated utility. Four practical constraints complicate this decision. First, prices should be perceived as fair in that they protect consumers against the utility’s monopoly power. Second, the regulator should ensure that customers jump to available bypass alternatives only when efficient. Third, the marginal cost data needed for a first-best pricing decision are difficult to obtain, especially for a bypass alternative. Fourth, the utility should have an incentive to lower its own costs and to respond efficiently to bypass threats.

Let R( 4) represent the usage-sensitive revenue that the utility obtains for customer usage 4; let A represent its access fee. If the utility faces neither a binding fairness constraint nor bypass competition, curve BDEGH in Fig. 1 illustrates a profit-maximizing nonuniform price schedule, P,( 4) = dR( 9) ldq, and the marginal usage cost C (see Spence, 1977). The u subscript indicates a price that is unconstrained by bypass and fairness concerns. If customer demand were deterministic, this nonuniform price schedule would be equiva- lent to a menu of two-part tariffs that the utility may offer;’ let (A, P) represent a pair of vectors of access and usage prices in the menu. To determine the

B D

E

price P(q) r- PC(S)

P,(q)

price Pf --

‘;i

F G

customer usage qi qmax

Fig. 1.

’ Regarding stochastic demand, if customers must select a two-part option prior to knowing a stochastic demand parameter, the two strategies are identical in an expected value sense. Based on the actual value of the demand parameter, a nonuniform price schedule would have the added benefit of ex post shifting a customer to his best two-part tariff if his actual demand were to differ from his expected.

284 M. A. E&horn I Incentive mechanisms for cost revelation with intermodal competition

two-part tariff (A i, Pi) that corresponds to the nonuniform price schedule at the instantaneous price P( q,), set P, = P( qi) and Ai = A + R( q,) - Pjq, .*

If the utility were regulated, the resulting profit-maximizing prices, P,(q) in Fig. 1, probably would be deemed excessive. To handle this concern, regulators may specify one two-part tariff, with access and usage prices A, and P,, that they deem to be fair to both the utility and its customers. Among other objectives, the fair tariff must adequately cover the utility’s revenue require- ments. To protect consumers against monopolistic pricing, regulators then impose a fairness constraint: no customer can be worse off with any chosen menu tariff than under the fair tariff (A,, P,).

Once regulators specify the fair tariff, the utility may design a menu of alternative two-part tariffs that any customer may select. Ruling out dominated choices and quantity constraints, the available items on the menu must combine increasing access prices with decreasing usage prices. Subject to the fairness constraint, the utility will design its tariff menu to maximize its profits. Brown and Sibley (1986) and Heymann et al. (1987) show that a profit-maximizing utility subject to this fairness constraint can do no better than simply to add (A,, P,) to its menu of choices and design other two-part tariffs (or equivalent- ly, a nonuniform price schedule) around it. This makes imposing the fairness constraint a simple, practical matter. Curve BDFGH in Fig. 1 represents a nonuniform price schedule P,(q) with a fairness-constraint at the usage

price P,. With the commission’s fair tariff available to all interested takers, a customer

would select any of the utility’s alternative tariffs only if she were weakly better off under the alternative. If the tariff (A,, P,) were deemed to be fair, any alternative that a customer voluntarily selects could reasonably be perceived as fair as well. Since the utility voluntarily offers each alternative, it is made better off as well. If customer demands were independent, the selection of any alternative tariff represents a weak Pareto-improvement over (A,, P,) [Willig (1978), Ordover and Panzar (1980)].

3. Bypass alternatives

Suppose that each consumer has the choice of installing a bypass system and foregoing utility service altogether. A customer would bypass if the anticipated consumer surplus were higher under the former. We now demonstrate that a bypass constraint is equivalent to a fairness constraint and then consider how the utility-without regulator cost measurement+an modify its price schedule or tariff menu to combat the competitive dangers that bypass poses.

* Without constraints on its shape, the price schedule P,(q) may be upward-sloping in parts,

depending on the distribution of customer demand intensities (Spence, 1977). Under this circumstance, two two-part tariffs in the menu would have identical usage prices but different access prices. If both were available to all takers regardless of usage, one tariff would obviously dominate the other; however, if the utility were permitted to specify quantity constraints with each tariff, both could be offered simultaneously.

M.A. Einhorn I Incentive mechanisms for cost revelation with intermodal competition 28.5

3.1. Notation and assumptions

Let z and c represent the respective access and usage costs of the bypass technology. Assuming that bypass vendors constitute a competitive market and that market rivals do not strategically interact with one another, bypass prices for access and usage will be driven to their respective marginal costs z and c. Customer i will prefer utility (bypass) service when the indirect utility y.(A, R(q)) > (<)Vi(z, c); if equality holds, the customer is bypass-indifferent.

We assume that a bypass connection entails a larger periodic fixed cost than a utility connection, i.e., t > 2, where Z is the fixed cost of a customer to a utility. For customer usage 4, bypass is economically inefJicient (ejjkient) if z + cq > (c)Z + Cq. If marginal usage cost c 3 C, bypass would evidently be inefficient at all levels of usage q; it could occur nonetheless if the utility were to continue to price a customer’s usage above marginal cost C, as is now often the case. If c < C, bypass would be economically inefficient (efficient) at levels of usage that are below (above) q* = (z - Z) /(C - c) > 0.

A desirable regulatory strategy is to permit bypass if and only if it is economically efficient. In order to set appropriate prices for the utility, regulators would need to know the marginal costs of utility and bypass service (as in Einhorn, 1987). This requirement is complicated because estimation of relevant marginal costs is difficult and because nonutility vendors are not legally required to report data to commissions. Consequently, there is consider- able room for strategic misrepresentation by all contending parties.

3.2. The bypass constraint

If the bypass option (z, c) were available to each utility customer, the utility would specify its nonuniform price schedule (A, R(q)) or its tariff menu (A, P) to maximize its profits subject to two constraints. First, each customer i who strongly prefers bypass will forego utility service altogether; therefore,

Vr(AY R(q)) 2 Y( z, c must hold for each customer i who retains utility service. ) Second, no utility customer i can be worse off under the utility’s schedule (A, R(q)) than under the regulator’s fair tariff (A,, Pf), i.e., y(A,, P,) G

Vi(A, R( 4)). If the utility were determined to keep all of its original customers, it would

design its tariff menu (A, P) so that each customer weakly prefers at least one tariff (A;, Pi) to both the fair tariff (A,, P,) and the bypass technology (z, c). Under these circumstances, we can conceive of the bypass alternative as a second fair tariff. Following Brown and Sibley (1986) and Heymann et al. (1987), the utility can most profitably meet this second fairness constraint on (2, c) in precisely the same manner as it met the regulator’s original fairness constraint on (A,, P,)-i.e., establish one uninterrupted horizontal plateau at the usage price c. Assuming that C < c < P,, Fig. 2 illustrates a constrained price schedule P,(q). By incorporating two plateaus, one at P, and one at c, the utility could most profitably deter all bypass and preserve fairness. With the equivalence of a nonuniform price schedule and a menu of optimal tariffs, the

286 M.A Einhorn i Incentive mechanisms for cost revelation with intermodal competition

P,(q)

price P(q)

price G __I_-_----

marginal cost c --_I-------_-

-

customer usage qi

Fig. 2.

utility may meet this double constraint by offering a menu of tariffs (A, P) that includes both options (A,, Pf) and (z, c).

The utility may permit some customers to bypass, which it could do if it were to restrict the availability of the tariff (z, c). Suppose that the utility offers a menu of two-part tariffs (A, P) that does not include the bypass tariff (z, c). Let H represent the set of customers who strongly prefer a utility tariff (Aj, Pi) in (A, P), and let h represent those who prefer (z, c) and who may therefore opt for bypass.

If the utility were then to add tariff (z, c) to its menu without changing any other tariff, no consumer i E h would have any positive incentive to bypass the utility. The utility’s net revenues from retaining any customer i E h with usage qi would be (z - 2) + (c - C)qi; as explained, z > 2. If c Z= C, any retained customer would be profitable to the utility at all usage levels qi. Since each customer i E H would strongly prefer an alternative tariff in menu (A, P) to the bypass option (z, c), no customer i f II would select (z, c) if the utility were to offer it. Under these circumstances, the utility may increase its profits simply by incorporating the bypass tariff (z, c) into its tariff menu (A, 2’) and offering it to all interested takers. Notice that the incentive to add (z, c) to any menu continues regardless of what else is in (A, P). Even a utility that did not select (A, P) to maximize profits still has a local incentive to add (t, c). Furthermore, the incentive to add (z, c) prevails whether or not customer demand curves cross one another. This generalizes Einhorn (1987), which assumed that demand curves do not cross one another.

M.A. Einhorn I Incentive mechanisms for cost revelation with intermodal competition 287

If c < C, customer i E h would be profitable only if 4, < (z - Z) /(C - c) = q*; therefore, the option (z, c) could be offered profitably only at customer usage levels qi < q*. If tariffed at (z, c), customers who use above breakpoint q* would represent an earnings loss to the utility. To avoid this, the utility would need to increase the price of customer usage beyond q* at least to marginal cost C, which would lead the customer to bypass. Therefore, a profit-maximizing strategy against bypass is simply to offer the option (2, c) for all usage levels q < q*, but to charge its respective marginal cost C > c for all usage levels q > q*.

It immediately follows that bypass would occur in the above situation if and only if it were economically efficient. Given this result, regulators evidently can ensure efficient bypass decisions without having to measure any marginal cost. Furthermore, while marginal costs may be difficult to measure, a profit- maximizing utility would want to estimate each of these costs as accurately as possible, to design its menu accordingly, and to respond immediately if costs change. The ability of our incentive mechanism to prevail over imperfect information is its most compelling feature and what distinguishes it from much earlier work.

4. Multiple access lines

To this point, we have assumed that each customer makes one discrete decision regarding choice of utility service-whether to bypass the regulated company entirely. This case may be relevant to natural gas distribution and electricity service, where customers often make discrete choices. However, telecommunications customers may install several circuits that usually include a simultaneous mixture of bypass and switched access.

As shown in Einhorn (1987), the results from an optimal nonuniform pricing schedule can be extended to a multiline model provided the marginal usage price on each switched access line is a nonincreasing function of line usage, i.e., dP( q) ldq d 0. This constraint ensures that each customer will attempt to concentrate calls over as few lines as possible and to route calls over available lines in an unchanging order of preferences. To ensure fair pricing on each switched access line, regulators may still design one tariff (A,, P,) that each customer may select for any switched access line. Each customer would be free to “mix and match” among the regulator’s tariff (A,, Pf), the utility’s alterna- tives (A ;, Pi), and the bypass technology (2, c).

With reduced usage rates made available for heavily used lines, resellers of utility service could capture some smaller utility customers by concentrating them on a circuit with a lower usage price in its tariff, which could reduce utility revenues (see White, 1982). However, such resellers would always have the option of installing bypass lines instead and utility discount pricing could stop these resellers from routing calls over bypass lines. Consequently, the mechanism would probably save more money than it loses.

288 M.A. Einhorn I Incentive mechanisms for cost revelation with intermodal competition

5. Determining fairness

Regarding fairness, Ramsey prices (Baumol and Bradford, 1970; Ng and Weisser, 1974; Schmalensee, 1981) are inherently discriminatory and would probably not be appropriate. Some have proposed procedures for determining fair prices (Kolm, 1973; Varian, 1976; Pazner and Schmeidler, 1978) or for allocating utility costs fairly (Schmeidler, 1969; Loehman and Whinston, 1971; Billera and Heath, 1982); however, Baumol (1986a) points out the impracticali- ty of these methods in the current regulatory arena. Baumol (1986b) advocated to the FCC that no utility service be permitted to recover more revenue than its associated stand-alone cost or less revenue than its incremental cost; however, the commission concluded that rates based on stand-alone cost could be excessive and would necessarily involve “paper engineering” of hypothetical utility systems. More practically, fully distributed cost methods, while not efficient (see Baumol et al., 1987), are generally designed to cover the utility’s anticipated costs and also carry some received sanction of fairness, however unrigorous. Furthermore, the necessary data requirements for such methods involve accounting costs that are not difficult to ascertain. Using status quo rates as (A,, P,) appears in Zajac (1978), Brown and Sibley (1986), the FCC’s initial price-cap decision (FCC, 1987), and a recent research report on incen- tive mechanisms, commissioned at the Federal Energy Regulatory Commission (Brown et al., 1989).

Eventually, changes in costs and demands will make it necessary for reg- ulators to adjust the fair tariff. Moreover, if economic bypass does occur, either per unit fixed or marginal costs for the remaining utility customers could be higher; as a result, either A, or P, must be increased to keep the utility solvent. If applied to this case, the pure price-cap approach would adjust the compo- nents of the fair tariff according to some formula that is based on long-term productivity trends in the industry but not on the actual cost experience of the regulated company. The price-cap mechanisms that have actually been used may adjust prices after several years by performing a traditional cost analysis of the regulated firm; however, such an approach might undermine the optimality properties of the system proposed here, because periodic reinitialization on the basis of cost experience would give the utility some incentive to prevent bypass with inefficiently low tariffs for bypass customers. Thus, the tariff-menu approach, built around an adjustable fair tariff, requires long-term adherence to a price-adjustment method that does not depend on the utility’s own costs.3

6. Conclusion

We have demonstrated that regulators may cover revenue requirements, ensure fairness, and deter uneconomic bypass with an incentive mechanism that

3 A complete evaluation of price-cap procedures is beyond the scope of this article. For recent evaluations and criticisms of various price-cap approaches, see Rand Symposium on Price-Cap Regulation (1989), Brown et al. (1990), and Einhorn, ed. (1991).

M. A. Einhorn I Incentive mechanisms for cost revelation with intermodal competition 289

can streamline their workload considerably. No regulator measurement of utility or bypass marginal cost is necessary. Instead, regulators define one tariff (A,, Pr), which the utility must offer to all takers. The utility may then specify

as many alternatives as it wishes, including those designed particularly to combat bypass. With the possibility of positive profits, the utility has every incentive to estimate its own and its rivals’ marginal costs as accurately as possible, to price accordingly, to minimize its own costs, and to respond to competitive challenges immediately. Other bypass-prevention procedures (e.g., Einhorn, 1987) often required that regulators estimate marginal cost and therefore permitted neither the accuracy nor the immediacy that our suggested approach now offers.

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